South Korea: Success containing pandemic not translating into flows
The first case of the virus now designated COVID-19 was detected last December. The epidemic, which became a global pandemic during 1Q20, had an immediate impact on nearby South Korea.
At first markets viewed Korea, whose response to the pandemic garnered widespread accolades, as a haven. By late March, however, the bloom had come off the Korean rose with Korean Equity Funds compiling a 12-week, $10 billion outflow streak that ran into mid-June (see chart below).
The challenge this reversal poses to investors, especially those whose mandates require them to maintain positions in Korea is a simple one: How to flourish in a sea of pessimism.
Not a good picture
Korea’s recent fall from grace can be illustrated by its fall from the top to the bottom quintiles of the flow-based indicator created by Srimurthy et al.
The histogram below shows cumulative fund flow into emerging markets from cross-border equity funds over the trailing four weeks to 8th January. Each emerging market is ranked on four-week flow percentage and assigned to one of five buckets. At that point, South Korea fell into the top, or most attractive, quintile.
Now, however, the picture is very different. Despite an election that gave incumbent President Jae-in’s Democratic Party an outright majority in the National Assembly, sharply reduced oil bills for a country that imports nearly all that it uses and Korea’s successful pandemic containment, the histogram below shows that by the second half of June Korea had slipped into the bottom quintile.
This altered landscape requires new approaches from investors to generate short-term alpha.
Stocks and factors
One option is to drop down from the country to the stock level and, when there, utilize quantitative factors.
EPFR collects stock-level allocations of individual funds. The positions themselves cannot be divulged to clients. However, EPFR can compute average flows, weightings, or other quantitative factors by aggregating across the universe of funds that report this data.
One of the factors we compute is Flow Diffusion. This is the product of flow and the sign of month-over-month change in allocations (+1/-1 for adds/trims respectively), summed across all funds. This is then scaled by absolute fund flows across all those same funds. In Greek, this works out to (∑φ×sgn(∆ω))⁄(∑|φ| ), where φ represents fund flow and ∆ω represents monthly allocation change. As a last step, for each stock, a moving average of this variable is computed over the latest-available forty-day period.
Another factor of interest, particularly for Korean stocks, is the fund-count factor of Chen, Hong and Stein. This, for each stock, is merely the number of funds owning that stock.
Applying the top two
We back-tested these two factors on the constituents of MSCI Korea, rebalancing monthly, over the period from early 3Q11 through mid-1Q20. The table below shows the return difference between the top and bottom fifth of Korean stocks, sorted on these variables. The average return difference, as well as the associated Sharpe ratio, have been annualized for both factors.
As the table illustrates, these factors work well for Korean equities. The return difference between the top and bottom fifth of Korean stocks is reasonably consistent. The chart below shows these for each calendar year.
In short, although Korea might have fallen out of favor of late, the toolkit for those investors who chose to invest in the Korean equity market still contains some handy instruments.
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